Hospital services Inc. pro-vides health care services primarily in the western part of the United States. The firm operates psychiatric hospitals that provide mental health care services using inpatient, partial hospitalization, and outpatient settings. In spring 2015, the firm is considering an investment in a new patient-monitoring system that costs $ 6 million per hospital to install. The new system is expected to contribute to the firm’s earnings before interest, taxes, depreciation, and amortization (EBITDA) via annual savings of $ 2.4 million in years 1 and 2, plus $ 4.25 million in year 3.
The firm’s CFO is interested in investing in the new system but is concerned that the savings from the system are such that the immediate impact of the project may be to dilute the firm’s earnings. The firm has just moved to an economic profit– based bonus system, and the CFO fears that the project may also make the individual economic profit’s of the hospitals look bad— a development that would generate resistance from the various hospital managers if they saw their bonuses being decreased.
Assume that the cost of capital for the project is 15%, the firm faces a 30% marginal tax rate, it uses straight-line depreciation over a three-year life for the new investment, and it has zero salcage value. Calculate the project’s expected NPV and IRR.
Calculate the annual economic profits for the investment for years 1 through 3. What is the present value of the annual economic profit measures discounted using the project’s cost of capital? What potential problems do you see for the project?
Calculate the economic depreciation for the project, and use it to calculate a revised economic profit measure following the procedure laid out in Table 7-8. What is the present value of all the revised economic profit measures when discounted using the project’s cost of capital? (First, revise the initial NOPAT estimate from your answer to Exercise 7-2a by subtracting the economic depreciation estimate from project free cash flow calculated in Exercise 7-2a. Next, calculate the capital charge for each year based on invested capital less economic depreciation.)
Using your analysis from Exercise 7-2b and c, calculate the return on invested capital (ROIC) for years 1 through 3 as the ratio of NOPAT for year t to invested capital for year t -1. Compare the two sets of calculations and discuss how the use of economic depreciation affects the ROIC estimate for the project.